B2: Strategic Planning: Forecasting, Budgeting, and Analysis Flashcards
Cost Volume Profit (CVP) Analysis For Decision Making
used by managers to forecast profits at diff levels of sales and production volume
- breakeven point: when revenues = total costs
- aka breakeven analysis
Assumptions
Cost Volume Profit (CVP) Analysis For Decision Making
General Assumptions*
- all costs are either variable or fixed costs
- volume is the only factor affecting cost
- costs behave in a linear fashion in relation to production volume
- cost behaviors anticipated to remain constant over the relevant range because there is an assumption that the efficiency of production does not change
- costs show greater variability over time; the longer the time, the greater the % of variable cost; the shorter, the greater the % of fixed costs
Use of Single Product
- CVP can be performed for more than 1, but in it’s simplest form, the model assumes product mix remains constant
Contribution Approach (Direct Costing) Used instead of Absorption Approach (GAAP) - * sales - variable costs - fixed costs = profit
Selling Prices Remain Unchanged
- the volume of transactions produces a uniform contribution margin per unit and predictable projected contribution margin based on volume
Absorption Approach
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
- GAAP
- does not segregate fixed and variable costs
- matching principle
Revenue
less: COGS (product cost/DM+DL+OH fixed and var)
= Gross Margin
less: Operating Expenses (period cost/SGA fixed and var)
= Net Income
Contribution Approach
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
- aka variable costing aka direct costing
- useful for internal decision making
Presentation
- Total or Per Unit
- revenue, var. costs, and CM may be expressed in total or per unit - Unit Contribution Margin = sales/unit - VC/unit
Contribution Margin Ratio* = CM / Revenue
Revenue less: Variable Costs (DM + DL + var. OH + var. SGA) = Contribution Margin less: Fixed Costs (fixed OH + fixed SGA) = Net Income
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
1 difference: treatment of fixed factory OH
- SGA are period costs under both methods
Treatment of Fixed Factory OH
- Absorption- Product Cost
- COGS = DM + DL + OH (fixed and variable)
- all fixed OH is product cost, COGS includes both fixed and variable - Contribution- Period Cost
- all fixed OH is period cost, expensed in period incurred
- inventory only includes variable OH so COGS does too
- not matching, that’s why not GAAP
Treatment of SGA Expenses
- period costs under both methods
Gross Margin vs Contribution Margin
Fixed OH differences Pass Key
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
Absorption Costing
- fixed OH of all units sold in product costs
Variable (Direct) Costing
- fixed OH of all units produced in period costs
- even if not sold
Effect on Income
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
if production = sales: no difference in NI
if production > sales: absorption NI > variable NI
- inventory increases
- in absorption, some fixed OH is included in inventory but in variable, all fixed OH is expensed
if production < sales: absorption NI < variable NI
- inventory decreases
- in absorption, fixed OH carried over from a pervious period as part of beg. inventory is charged to cost of sales
- in variable, those fixed costs were charged in a prior period when incurred
Benefits and Limitations of each
Absorption Approach vs Contribution Approach
Cost Volume Profit (CVP) Analysis For Decision Making
Absorption Costing Benefits - GAAP and required by IRS Limitations - **NI under absorption is less reliable (especially for use in performance evaluations) than variable bc cost of product includes fixed costs and therefore, the level of inventory affects NI
Variable Costing
Benefits
- variable and fixed costs are separated and can be easily traced to and controlled by mgmt
- NI is more reliable than under absorption
- isolates contribution margin to aid in decision making
Limitations
- not GAAP
- IRS doesn’t allow
Breakeven Computation*
Cost Volume Profit (CVP) Analysis For Decision Making
Breakeven = Sales - VC - FC = Profit
CM = Sales - VC
- * always use pre-tax profit
Breakeven Analysis: determines the sales required (in $s or units) to achieve 0 profit or loss from operations
Breakeven Point in Units
= total fixed costs / CM per unit
Breakeven Point in $s
- CM per unit
- breakeven point = unit price * breakeven points in units - CM Ratio
- breakeven point = total fixed costs / CM ratio
- CM ratio = CM / revenue
Required Sales (in $s and units) for Target Profit
Cost Volume Profit (CVP) Analysis For Decision Making
- must be pre-tax profit
Sales Units Needed for Desired Profit
= (fixed cost + pretax profit) / CM per unit
Sales $s Needed for Desired Profit
- summation of total costs and profits
- sales dollars = variable costs + fixed costs + pretax profit - CM ratio
- sales dollars = (fixed costs + pretax profit) / CM ratio
Predicting Performance Based on Volume
Cost Volume Profit (CVP) Analysis For Decision Making
Predicting Profits Based on Volume
- after breakeven has been achieved, each add. unit sold will increase NI by the amt of CM per unit
Setting Selling Prices
- sales price per unit = (fixed costs + var. costs + pretax profit) / # of units sold
Margin of Safety
Cost Volume Profit (CVP) Analysis For Decision Making
= excess of sales > breakeven sales
- in dollars
total sales $s - breakeven sales (in $s) = margin of safety - in %
margin of safety in dollars / total sales = margin of safety %
Target Costing
used to establish the product cost allowed to ensure both profitability per unit and total sales volume
- sales price given
- target cost = market price (given) - required profit
Implications ~
- if mgmt commits to a target cost, serious measures must be employed to reduce costs
- compromised quality
- increased marketing and downstream costs
- increased complexity in cost measurement- to attain a higher productivity level
- product redesign
Transfer Pricing (Non-Global Perspective)
transfer price is price charged for sale/purchase of a product internally
- price set determines revenue for selling and cost of purchasing
- selling division wants higher price and purchasing wants lower price
- Negotiated Price
- selling division will not accept price lower than variable cost to produce and sell the product
- purchasing will not accept price higher than market price - Market Price
- if outside market exists
- price could be reduced by selling division due to costs saved from not having to market or distribute - Cost
- at least variable costs + possibly fixed OH + possibly reasonable profit markup
- when no outside market exists
Transfer Pricing (Global Perspective)
concern from tax authority is that a comp will assign revs and exps to show lowest profit (biggest loss) in high tax jurisdiction and highest profit in lowest tax jurisdiction
Arms Length Principle
- transfer prices must approximate prices for comparable transactions b/w unrelated parties
to determing comparability, assess:
- nature of goods, services or property
- B2-14
2 categories of methods: Transactional and Profitability
- Transactional required identification of comparable transactions
- Profitability used when identifying comparable transactions is not feasible
Penalties, Rules, Adjustments
- in US, the IRS has authority to adjust prices not found to be established at arm’s length
- adjustment can be to midpoint of range and a penalty may be assessed depending on size of adjustment
Transactional Methods
Transfer Pricing (Global Perspective)
Comparable Uncontrolled Price (CUP)
- CUP identified an identical transaction
- best estimated of arm’s length
Resale Price Method
- list price less a discount % from retail sales to unrelated parties
Gross Margin
- similar to resale price method, but used for transactions involving services
Cost Plus (C+)
- looks at markup % applied on actual costs on transactions b/w unrelated parties
- an average markup is determined and applied
Profitability Methods
Transfer Pricing (Global Perspective)
Comparable Profits Method
- companies in similar situations and industries to determine profit margins
Transactional Net Margin Method
- looks at individual transactions (or groups) from a profitability perspective (rather than price) and applies that profitability
Profit Split Method
- based on evaluating the contribution of each tested party to the combined operating profit or loss of the entity as a whole
1. Comparable Profit Split - combined operating profit of uncontrolled taxpayers w similar transactions to allocated combined operating profit
2. Residual Profit Split - when 1 party owns majority of intangible assets
- profit split based on functions performed by party that does not own intangible assets, residual allocated to other party
Marginal Analysis and Definitions
is the operational decision method used when analyzing business decisions
- only considers relevant revenues and costs associated w a decision
Relevant Revs and Costs
- relevant only if they change as a result of selecting different alternatives
- can be fixed or variable, but more likely variable bc change w production volume and output
Direct Costs: can be traced to a cost object
- usually relevant (variable costs gr direct costs)
Prime Costs: DM + DL
- gr relevant
Discretionary Costs: costs from periodic budgeting decisions by mgmt to spend in areas not directly related to manufacturing
- relevant
Incremental Costs
- aka marginal costs
- add. costs to produce add. amt of unit
- relevant and include all variable costs and any avoidable fixed costs
Opportunity Costs
- cost of foregoing next best alternative when making a decision
- always relevant
Irrelevant Costs
- costs that do not differ among alternatives are ignored
Sunk Costs
- unavoidable bc incurred in the past and can not be recovered
- not relevant costs
Controllable Costs
- authorized by decision maker
- relevant if they will change as a result of selecting diff alternatives
- uncontrollable costs are not relevant
Avoidable Costs and Revs
- result from choosing one course of action instead of another
- relevant
Unavoidable Costs
- not relevant
Special Order Decisions
Marginal Analysis
decide whether a specially priced order should be accepted or rejected
- decision rule: accept if price > relevant cost
Capacity Issues
- fixed costs gr not relevant to these decisions unless special order will change total fixed costs
a) Excess Capacity: accept if price > VC/unit
b) Full Capacity: accept if price > VC/unit + opp cost/unit - opp cost/unit = total CM given up / size of special order
Strategic Factors
- B2-19
Make vs Buy
Marginal Analysis
decision rule: make if relevant costs < outside purchase price
Excess Capacity
- relevant costs = avoidable costs
Full Capacity
- relevant costs = avoidable costs + opportunity costs
Strategic Factors
- B2-20
avoidable costs
fixed costs that could be eliminated
Sell or Process Further
Marginal Analysis
decision rule: process further if incremental revenue > incremental costs
Joint Costs
- considered sunk costs, not relevant!
Separable Costs
- costs incurred after split-off point
- relevant
Keep or Drop a Segment
Marginal Analysis
Classification
- fixed costs associated w the segment must be identified as avoidable (relevant) or unavoidable, even if seg. is discontinued
Decision
- keep if lost contribution margin > avoided fixed costs
- aka cost to give up > benefit
Strategic Factors
- B2-23
